The Economics Behind the Individual Mandate

In regards to the big Supreme Court decision on RomneycareObamacare, there's been much hand-wringing on how this is a tax on doing nothing. This does seem odd, until you realize that a penalty or tax on one group but not on a second group is economically identical to having no penalty or tax on the first group but a tax credit or a subsidy for the second. Either way, it's a transfer payment from the first group to the second group. Economist N. Gregory Mankiw made this point a few years ago:

...consider two proposals:

1. A person is required to have health insurance. If a person is in violation, he pays a $1000 fine. The revenue from the fines is rebated lump-sum to all taxpayers.
2. A person is not required to have health insurance, but those with health insurance receive a $1000  tax credit. The cost of the tax credit is financed with a lump-sum tax on all tax payers.

Notice that there is no economic difference between these two scenarios. The difference is purely semantic.

A subsidy or tax credit for a certain activity, such as buying a house, getting married, having children, and growing certain crops, is economically equivalent to a tax on inactivity. The mortgage deduction can just as easily be labeled a renter's penalty or tax. So while it irks me that Obama wasn't more up-front with the mandate actually being a tax, it's economically identical to a tax credit for those who purchase health insurance (much like Paul Ryan's plan).

Now generally I oppose most such transfers because they are often thinly-veiled kickbacks resulting from corporate lobbying for artificially high profits (economists call this "rent-seeking"), but while there's plenty of rent-seeking fingerprints on Obamacare, the health insurance mandate tax is a little bit different. Here's why.

Markets are wonderful things that coordinate vast amounts of decentralized activity, and they generally allocate resources very efficiently. There are, however, well-known cases where markets fail to do so. The most well-known are transactions where there is a cost or benefit that is not borne by the buyer nor the seller, known as externalities. Pollution is one example, and the market tendency will be to over-pollute. One textbook solution is for the government to enact a tax so one party will take into account the cost that they are imposing on others (although are other ways to approach the problem).

A more complex market failure is information asymmetry, where one person in a transaction knows more than another person. This is quite common in Wall Street (e.g. the complexity of derivatives and the opacity of mutual fund fees), and indeed it played a crucial role in the financial crisis. Many people misunderstand it to mean when the seller knows more than the buyer, as in lemons in the used-car market, but it also occurs when the buyer knows more than the seller, and in a nutshell, that is the insurance market.

In a world of perfect information, insurance companies would be able to accurately project someone's healthcare costs and charge them an appropriate premium. In the real-world, people know far more about their health than insurers. Although insurers can uncover pre-existing conditions through applications and exams, this only narrows the information gap somewhat.

So insurers end up charging a premium that will be a good deal for some people (the sick) and a bad deal for others (the healthy). The healthy opt out, resulting in the pool of insured becoming dominated by sick people. Costs go up more, premiums go up further, more healthy people opt out, etc. After a while, the whole point of insurance — risk-pooling — is thwarted. This is known as adverse selection. This certainly isn't the only market failure in healthcare, and there are a number of ways to address it, but this is the economic reasoning behind the individual mandate. 

Per The Economist: "One way to reduce adverse selection is to make the purchase of insurance compulsory, so that those for whom insurance priced for average risk is unattractive are not able to opt out" (emphasis mine). That is the goal of the mandate, to lower insurance costs by addressing adverse selection. Indeed it has its roots from the Heritage Foundation and as a proposal by conservative economist Mark Pauly (H/T Ezra Klein). As we all know, it was implemented by Mitt Romney — and then both parties flip-flopped on it.

Still, as Mankiw noted:

A mandate is only as effective as the penalty backing it up. No one, as far as I know, is ready to make failure to be insured a criminal act punishable by jail time. Instead, if a person fails to follow the mandate, he merely pays a penalty. So the mandate is really just a financial incentive to have insurance.

So what we have here is, as the Supreme Court noticed, more akin to a tax on the externality caused by a person's conscious choice not to purchase insurance which results in higher healthcare costs for everybody else. Ludwig von Mises would probably categorize this choice as purposeful behavior that constitutes human action. Heck, the great Canadian rock-trio Rush even realizes that "If you choose not to decide, you still have made a choice."

When that choice imposes costs on other people, a tax is economically appropriate.